FY20 forecasts vs stretched valuations leave little room for error

Stocks enter the August reporting season with very low expectations for FY19 on aggregate. Consensus expectations for FY19 EPS growth (excluding Resources stocks) have eroded from around 4.7% post February results to only 1% heading into August. This has been a persistent theme for 3-4 years now.

So while we think that results can clear this low hurdle for FY19, we do worry about:

1. current consensus FY20 EPS growth expectations looking look too heroic at ~8%; and
2. aggregate industrials valuations at a decade high 17.5x (12-month forward PE multiple) leaving very little room for error in FY20 outlook commentary versus consensus expectations.

Capital management once again in focus

Lower rates have again fueled the 'yield' trade. A mix of slowing economic growth, interest rate cuts and companies dialling back expansion capex have created an ideal environment for yield investors.

We think upside surprise to capital management may again feature in August. Investors have sought returns in defensively oriented names since the February reporting season.

However, we're uneasy about this dynamic in the context that EPS expectations, which support DPS expectations, have continued to erode.

Pay close attention to the sustainability of future capital returns.

Growth names have defined 2019

Our basket of Growth bellwethers has outpaced Value by 41% YTD, and this highlights the ongoing trend of high PE stocks re-rating further against the pool of lower valued stocks. The spread is now 18 PE points vs the 10-year average of 10.

A slowdown in the economic climate and falling interest rates have contributed to the appeal of growth, extending valuations further.

However, as the focus turns to domestic earnings and given expectations are higher than ever, we could be nearing the eventual cyclical turning point.

Tactical positioning ahead of the August results

We think that avoiding the downside is as important as identifying the upside in the current climate. Our research analysts flag key candidates for potential upside and downside reactions to results relating to reported earnings, outlook statements, capital management and/or other catalysts

Several stocks to watch in August:

• Potential to beat expectations – A2 Milk, AP Eagers, Medibank Private, Australian Finance Group
• Deliver on capital management – BHP Group, Rio Tinto, Origin, Aurizon
• Solid fundamentals – Treasury Wine Estate, Cleanaway Waste, Telstra

Importantly, we also flag several stocks to avoid:

Nanosonics, Bellamy's, NextDC, Carsales.com, Flight Centre, Coca-Cola Amatil, CSL Limited, REA Group, AGL Energy, Woodside Petroleum.